I have been fairly bullish in these pages and I remain cautiously bullish today. However, successful investors and traders look at the other side of the coin to see what could go wrong with their thesis. Today, I write about the bear case, or what’s keeping me up at night.

The signal from emerging market bonds
James Carville, former advisor to Bill Clinton, famously said that he wanted to be reincarnated as the bond market so that he could intimidate everyone. The message from the bond market is potentially worrying. In particular, emerging market bonds are selling off big time. The chart below of the emerging market bond ETF (EMB) against the 7-10 year Treasury ETF tells the story. The EMB/IEF ratio broke an important relative support level, with little signs of any further support below the break.

Technical breaks like these are sometime precursors of a catastrophic event, much like how the crisis in Thailand led to the Asian Crisis. For now, the concerns are somewhat “contained”. Yes, junk bond yileds have spiked…

On the other hand, the relative performance of high yield, or junk, bonds against 7-10 year Treasuries remain in a relative uptrend, which indicates that the trouble remains isolated in emerging markets.

Here is the relative performance of emerging market bonds against junk bonds. They have been in a multi-year trading range. Should this ratio break to the downside, it would be an indication that something is seriously wrong in EM that smart investors would be well advised to sit up and take notice of.

For now, this is just something to watch.

Are European stocks keeling over?
The second area of concern is Europe. Despite my bullish call on Europe (see Europe healing?) European stocks have been performing poorly in this correction. As the chart below of the STOXX 600 shows, the index has fallen below its 50 day moving average, though the 200 day moving average has been a source of support in the past.

The 200 dma is my line in the sand.

Faltering sales and earnings momentum
In the US, high frequency macro indicators are showing a pattern of more misses than beats, as measured by the Citigroup Economic Surprise Index.

Ultimately, a declining macro outlook will feed into Street sales and earnings expectations for the stock market. Ed Yardeni documented the close correlation between the Purchasing Managers Index against revenue estimates.

Viewed in this context, the PMI “miss” last week is especially worrying. Indeed, Yardeni showed that the Street’s forward 52-week revenue estimates are now ticking down. Unless margins were to expand, which is unlikely, earning estimates will follow a downward path and provide a headwind for equity prices.

As Zero Hedge aptly puts it, this is what you would believe if you were buying stocks right now:

My take is that the downturn in high frequency economic releases a concern, but it is something to watch and it’s not quite time to hit the panic button yet. I agree with New deal democrat in his weekly review [emphasis added]:

After several weeks of more positive signs, last week we returned to the pattern of gradual deterioration that began in February. This week most indicators remain positive and there were fewer negatives…

Last week I said that for me to be sold that the data is actually rolling over, I would want to see a sustained increase in jobless claims and a sustained deterioration in consumer spending. That wasn’t happening as of last week, and it certainly didn’t happen this week either. The economy still seems to be moving forward – but in first gear.

In summary, most of these concerns are on the “something to watch” list to see if any of these risks turn out to be more serious. My base case, for now, is that the market is undergoing a typical rolling correction, with leadership shifting from interest sensitive issues to deep cyclicals (see my recent postCommodities poised for revival). Until the late cycle commodity stocks roll over, there is probably more upside to stocks from these levels, but I am still looking over my shoulder and defining my risk parameters carefully.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest. None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

Look at this four-year weekly chart. Would you buy, sell, or hold this?

I will write about what it is on Monday and discuss it further.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest. None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

Yesterday’s stock market selloff was an event that we haven’t seen in some time, as major averages fell over 1% across the board – and globally. Nevertheless, I saw a glimmer of hope for the bulls, as commodities were performing well despite the carnage. If a deep cyclical sector like that is displaying rising relative strength, it suggests that the end of this correction may not be too far off.

Commodities unloved and washed out
Simply put, the commodities complex is unloved, washed out and showing signs of investor capitulation. The chart below from BoAML shows the aggregate large speculator (read: hedge fund) net position from the Commitment of Traders report in the CRB Index. Large speculators have liquidated their net long positions from a near crowded long level to net short. Moreover, readings are consistent where declines have halted in the past.

Here in Canada, the junior resource companies are beyond washed out. The chart below of the relative performance of the junior TSX Venture Index against the more senior TSX Composite is at all-time lows – and below the level of the capitulation lows seen following the Lehman Crisis.

Here in Vancouver, which is the heart of junior mining country, I personally know of scores of well-qualified people who are in the industry who are struggling with the difficult environment.

Green shoots
In the midst of this bleak landscape, I am seeing nascent signs of recovery for the sector. What is encouraging was the positive performance shown during yesterday’s ugly selloff. One of the top recent performers has been industrial metals, which has:

Rallied through a downtrend;

Staged an upside breakout through a wedge; and

Staged an upside breakout through a resistance level yesterday – which was impressive given the headwinds provided by the risk trade.

At the same time, gold seems to have made a temporary bottom and it’s starting to grind upwards as the precious metal is displaying nascent upside strength.

I am watching carefully the Brent price, which is a better proxy for world oil prices, for signs of an upside breakout through a downtrend. We almost achieved the breakout yesterday, but not quite.

The relative performance of energy stocks against the market is starting to show positive relative strength, which is another early warning of shifting leadership.

Macro and market implications
While I understand that commodities and commodity related stocks are unloved, washed out and poised to rally. These combination of sold-out sentiment and early signs of rising relative strength are pointing to a recovery in these sectors.

From a macro perspective, the recovery of deep cyclical sectors like these are consistent with a relatively upbeat outlook for growth economic growth. In that case, the environment for equities is encouraging and any correction should be relatively shallow – barring any macro surprises,

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest. None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

The old Cam would have been freaking out. The first version of my Inflation-Deflation Trend Allocation Model depended solely on commodity prices as the canaries in the coalmine of global growth and inflationary expectations. The chart below of the equal-weighte Continuous Commodity Index is in a well-defined downtrend. The weakness isn’t just restricted to gold, but other commodities like oil and copper are all falling.

However, we found with further research that adding global stock prices to commodity prices as indicators gave us a better signal, in addition to giving us a more stable signal.

Equities not confirming weakness
The three axis of global growth are the US, Europe and China. I am finding that signals from all three regions are not really confirming the signals of weakness given by falling commodity prices. Consider, for example, Caterpillar’s earnings report yesterday. The company, which is a cyclically sensitive bellwether, reported punk sales, earnings before the opening bell and revised their outlook downwards [emphasis added]:

We have revised our outlook for 2013 to reflect sales and revenues in a range of $57 to $61 billion, with profit per share of about $7.00 at the middle of the sales and revenues outlook range. The previous outlook for 2013 sales and revenues was a range of $60 to $68 billion and profit per share of $7.00 to $9.00.

“What’s happening in our business and in the economy overall is a mixed picture. Conditions in the world economy seem relatively stable, and we continue to expect slow growth in 2013,” said Oberhelman.

“As we began 2013, we were concerned about economic growth in the United States and China and are pleased with the relative stability we have seen so far this year. In the United States, we are encouraged by progress so far and are becoming more optimistic on the housing sector in particular. In China, first quarter economic growth was slightly less than many expected, but in our view, remains consistent with slow growth in the world economy. In fact, our sales in China were higher in the first quarter of 2013 than they were in the first quarter of 2012, and machine inventories in China have declined substantially from a year ago,” said Oberhelman.

“We have three large segments: Construction Industries; Power Systems; and Resource Industries, which is mostly mining.While expectations for Construction Industriesand Power Systems are similar to our previous outlook,our expectations for mining have decreased significantly. Our revised 2013 outlook reflects a sales decline of about 50 percent from 2012 for traditional Cat machines used in mining and a decline of about 15 percent for sales of machines from our Bucyrus acquisition,” said Oberhelman.

In other words, CAT remains upbeat on US housing. China is weak-ish and mining is in the tank. It seems that much of this negative outlook has been discounted by the market. While the stock fell initially, it rallied to finish positively on the day on heavy volume.

For now, the US economy look OK. I agree with New Deal Democrat when he characterized the high frequency economic releases as “lukewarm”. We are not seeing gangbusters growth, but there is no indication that the economy is keeling over into recession either. The preliminary scorecard from the current Earnings Season is telling a similar story. The earnings beat rate is roughly in line with the historical average, although the sales beat rate has been somewhat disappointing.

Risk appetite rising in Europe
Across the Atlantic, Europe is mired in recession. However, there is little sign that tail-risk is rising. I have been watching the relative performance of the peripheral markets in the last few days as stocks have weakened. To my surprise, European peripheral markets have been outperforming core Europe, indicating that risk appetite is rising. Here is the relative performance of Greece against the Euro STOXX 50:

Here is Italy:

…and Spain:

Well, you get the idea.

Weakness in China?
What about China? Chinese growth has been a little bit below expectations, such as the March Flash PMI released overnight. Shouldn’t weakness in Chinese infrastructure growth would be negative for commodity prices? Isn’t that what the commodity price decline is signaling?

Well, sort of. Maybe. We have seen a great deal of financialization of commodities as an asset class. An alternate explanation of commodity weakness is the unwind of the long positions of financial players . Indeed, analysis from Mary Ann Bartels of BoAML shows that large speculators have moved from a net long to a net short position in the components of the CRB Index:

One key gauge I watch of Chinese demand is the Australian/Canadian Dollar cross rate. Both countries are similar in size and both are commodity producers. Australia is more sensitive to Chines growth while Canada is more sensitive to American growth. As the chart below shows, the AUDCAD cross remains in an uptrend in favor of the Aussie Dollar, though it is testing a support region.

In conclusion, the preliminary verdict from the market is that commodity weakness is localized – for now. Barring further weakness in commodity prices and the other indicators that I mentioned, the implication is that US stock market action will be choppy because of the uncertainty caused by commodity weakness and Earnings Season, but any downside will be limited. As the point and figure chart of the SPX below shows, the S+P 500 remains in an uptrend and I am inclined to give the bull case the benefit of the doubt for now.

So relax and chill out.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

The weakness in equities last week was no surprise to me – though the trigger of the adverse liquidity effect the Fed removing QE was. As I reviewed the charts on the weekend, it became apparent to me that this week coming up could turn out to be pivotal in the tug-of-war between the bulls and bears.

Right now, it’s not clear to me whether the weakness last week will turn out to be a shallow correction or a much deeper one.

Cyclical stocks rolling over
As I documented last week (see Take some chips off the table) cyclically sensitive stocks are rolling over relative to the market. A review of some of the major sectors of the US stock market shows this to be the case. Consumer Discretionary stocks have violated an important relative uptrend against the market.

Cyclically sensitive Industrials can only be charitably characterized as testing a relative uptrend line:

The equal-weighted NASDAQ 100 as a proxy for Technology stocks, which minimizes the effect of heavyweight Apple, has violated a relative support level after rolling over out of a relative uptrend. (Believe me, the relative chart of Tech with Apple is much, much worse.)

The homebuilders, which had been a source of leadership and relative strength, are rolling over relative to the market:

Emerging defensive leadership?
Meanwhile, defensive sectors are rising in relative performance and they appear to be emerging as market leaders. Consider, for example, Consumer Staples:

…and Utilities:

A key test for the bulls and bears
The way I read it, cyclically sensitive stocks are faltering. Defensive sectors are rallying but have not fully assume the mantle of market leadership. This week coming up is a key test for bulls and bears alike.

First, there is the Italian election, where Silvio Berlusconi is attempting a comeback on an anti-euro platform (see this discussion by Joe Wiesenthal of Business Insider on the mechanics of Italian elections). A win by Berlusconi or a deadlocked government could really spook the markets.

The other is the looming sequestration cutbacks scheduled to take place on March 1. Based on the experience of the recent past, it seems that the markets have an ingrained Pavlovian response that there will be a last minute deal and remain relatively complacent about the outcome. I could go on and on about how to analyze the politics of sequestration, but I have no idea of the outcome.

I just know one thing for certain, we will have volatility.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

Well, that market reaction to the Spanish banking bailout was underwhelming! I wrote last week that seeing a market’s reaction to an event can be an important clue to future direction, as it is an indication of investor expectations and what news is priced in.

We now know the path of least resistance for stocks is down. We got the first hint last week from the lukewarm market reaction to the ECB announcement and Draghi press conference; and later the reaction to the Bernanke testimony (see my comment Is the QE glass half full or empty?).

Now that the bias for equities is bearish, what’s the short-term downside from here? Consider this note from Todd Salamone of Schaeffer’s Research published on the weekend, which suggests that technical selling by option market makers could exacerbate the downturn as we draw closer to Friday’s option expiry [emphasis added]:

The current open interest configuration on the SPDR S+P 500 ETF (SPY – 133.10) is very put-heavy, setting up the potential for short-covering related to the expiring put open interest at strikes immediately below the current SPY price. The odds are in the bulls’ favor, absent a negative outcome with respect to Spain over the weekend. That said, a poor start to the week spurred by ongoing euro-zone concerns could create the kind of delta-hedge selling that occurred last expiration month, when put strikes acted as “magnets” once the ball got rolling to the downside.

Here is how he explained the mechanics of delta hedging as it related to the option market and market makers may have contributed to the market decline in May:

As popular put strikes were violated one after another during expiration week, sellers of the puts may have been forced to short futures to keep a neutral position, creating a steady but sure stream of selling. The heavy put open interest strikes essentially act like “magnets,” as one strike after another is taken out. Delta-hedging risk certainly grows during expiration week if the market gets off to a weak start, as it did last Monday, and there is heavy put open interest just below current prices.

Salamone postulated that the SPX could find some support at the 1,280 and 1,250 level:

It’s usually the big put strikes that act like magnets, so 128 (which corresponds to SPX 1,280) would be a possible support area. There’s a smaller-probability risk of a move down to 125 (or SPX 1,250), which is the next strike with significant put open interest. On the upside, a move into heavy call strikes at 134 and 135 would be a possibility in the event of a short-covering rally. These areas correspond to SPX 1,340 and 1,350, respectively, which we cited above as potential chart resistance.

Given Monday’ market action, it is evident that the bears have the upper hand. Salamone’s comments put some further context to the short-term downside that US equities face this week.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

Support for the S&P 500 has held the initial test of the 1290 area we had been targeting in recent weeks. There should be scope for a retracement “bounce” to something less than the recent highs. If we are correct, there is more European debt inspired weakness in the coming months, compounded by a weakening US economy and more anxiety later in the year over the Presidential elections, and ultimately the US debt ceiling in early 2013.

Japan, the third largest economy in the world and the most indebted (where QE has been little more than a periodic adrenaline boost), was downgraded again overnight. Anyone who thinks it is not different this time just does not get it. To be a successful investor in this environment you have to take money off the table when the birds are chirping and have to get it back to work when all are despondent. We would hardly call last week’s selling a bout of despondency, so there are probably lower lows coming after a bounce.

Resistance between 1342 and 1372 is the zone to sell into in our current view, but that could change if the ECB cuts a check or the Fed cranks up the press in June.

Have US equities seen an intermediate term top? It was a rough week for stocks last week, but I believe that we are due for an oversold relief rally. We will need to watch how the market behaves in the next couple of weeks in order to truly determine whether an intermediate term top is in.

As the chart below shows, the market briefly tested the 50-day moving average and managed to rally above that support level and the longer term uptrend remains intact.

You would be forgiven for imagining that investors are allergic to owning stocks, given the data surrounding equity fund flows. For the last 12 months, as shown in Chart 4, below, investors have demonstrated at best a grudging affection for stocks.

These are typically not the kind of levels of sentiment indicator readings that mark the start of a major decline.

The NFP release a statistical blip?
In addition, the shocker of a 120K NFP release that was the catalyst for the recent stock market selloff may have been a statistical blip. Ed Yardeni outlined last week why he remains constructive on employment picture:

(1) The three-month average gain of payroll employment remains solid. Payrolls rose 211,700 per month on average during Q1-2012 vs. 164,000 during Q4-2011 and 127,700 during Q3-2011. Private-sector payrolls rose 210,300 on average during Q1 according to the official tally, in line with the 207,000 average gain for the payrolls tracked by ADP.

(2) The index of aggregate weekly hours worked for total private industries rose at a solid pace during Q1. It was up 3.7% (saar), following increases of 2.5% during Q4-2011 and 1.1% during Q3-2011.

(3) The household employment survey is up 414,700 per month on average over the past three months. That compares to gains of 227,700 during Q4-2011 and 240,700 during Q3-2011.

(4) According to the household survey, full-time employment rose 882,000 during March! That’s not a typo, and that’s after it rose 563,000 during February. On the other hand, part-time employment fell 664,000 during March after falling 163,000 during February. Full-time employment is up 4.8 million since its latest cyclical trough during December 2009 to the highest level since the start of 2009.

Also consider the latest batch of other employment indicators:

(5) During March, initial unemployment claims averaged 361,750, falling steadily from September’s average of 410,500. That’s a clear sign that the pace of firing is continuing to decline.

(6) A monthly employment index, which can be constructed from the available regional surveys conducted by the Fed districts and purchasing managers associations, remains strong. So far for March, data are available for the regions around the following cities: Chicago, Dallas, Kansas City, New York, Philadelphia, and Richmond. The average of these regional indexes fell from 14.5 during February to 12.2 last month. That’s still a relatively high reading.

(7) On Wednesday, Gallup reported a four-point jump in the polling firm’s Job Creation Index from 14 in February to 18 in March. That’s the best reading since August 2008. The latest poll also found that the pace of hiring is picking up: “The March Job Creation Index reflects 35% of U.S. adult workers saying their employers are hiring and expanding the size of their workforces, and 17% saying their employers are letting workers go and reducing the size of the workforces. While the percentage letting go matches what Gallup found in January, the percentage hiring is at a 42-month high, last seen in September 2008.”

(8) The employment component of the national manufacturing purchasing managers index (M-PMI) jumped from 53.2 in February to 56.1 in March, the best reading since last June. The nonmanufacturing survey’s employment index increased from 55.7 in February to 56.7 in March. The average of the M-PMI and NM-PMI employment indexes rose to 56.4 in March, the highest since last June.

(9) Wednesday’s ADP report also confirmed that the labor market remained strong during March. During Q1, the average gain was 207,000, little changed from Q4’s 211,700 and considerably above the 99,000 average during Q3 of last year.

What the bears say
Based on the analysis so far, one may be inclined to give the bulls the benefit of the doubt, but inter-market analysis reveals a far more bearish tone. There are a number of worrisome negative divergences that shouldn’t be ignored. For one, eurozone concerns are rising and the risk of financial contagion from Europe is rearing its ugly head again. European stocks have violated their uptrend and they have rolled over. The STOXX 600 Index, shown below, is now approaching the first technical support at the 61.8% Fibonacci retracement level.

In addition, commodity prices look punk.

The relative performance of the Morgan Stanley Cyclical Index is also following the pattern of commodity prices.

If we are truly seeing a recovery in the American economy, shouldn’t cyclical stocks be outperforming? In summary, we have trouble in Europe, weakening cyclicals and commodities. Do these look like the ingredients for a sustainable advance?

Staying on hold, but watching
Today, what we have right now is an oversold market that is due for a relief rally of at least 1-2 weeks in duration. In the meantime, Earnings Season is upon us with the possibility of margin compression weighing down the market (see my post Bad news is good news, good news is…). I am watching earnings reports carefully for whether margin compression is occurring this quarter, as I have to allow for the possibility that it may be pushed out to the next quarter’s earnings reports.

In summary, I wrote before that investors should maintain a balanced outlook between risk and return (see Time to take some risk off the table). My current stance is to watch how the market behaves and reacts to news in the next few weeks in order to get a better idea of intermediate term direction. Specifically, I am watching for:

Earnings and forward guidance: Are margins compressing now or next quarter?

Market leadership: How are the cyclicals and commodities behaving?

European news, as we have elections in France and Greece coming up soon and the fear of European contagion could rise.

Stay long, but keep tight trailing stops in place.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

Bernanke played the ace again yesterday in the face of other FOMC members talking about removing accommodation. In any case, it unleashed the quarter end window dressers a few days early and it took the market right up to the next area of resistance from the parallel channel of the lows from 2010 and 2011 projected from the 2011 highs is right around where we are going to open this morning.

Of note, mainland Chinese stocks (PEK) continue to falter and could be the leading indicator for this current phase of the market cycle—this should be on your front burner. The notion that the US can decouple from the rest of the world entering a slowing period is nonsense. Enthusiasm for US equities that can do no wrong and are being pumped by the US entertainment media (aka CNBC) gives us an almost giddy sense of benign neglect.

Investors looking to hedge the growing downside risk should avoid VXX for the toxic steepness of the futures curve and have a healthy mix of SPLV and SH to play the next few quarters.

Further to my post last week detailing signs of global healing, I have had a number of discussions with investors about the market outlook based on the events of 2008-2009. If we are indeed in a period of global healing, then can we expect the kinds of returns from stocks that we saw coming off the March 2009 bottom?

The answer is a qualified no.

Consider this chart of US equities spanning the periods in question. In 2008, the market crashed in the wake of the uncontrolled collapse of Bear Stearns and Lehman Brothers. In 2011, the European authorities manage to stem the panic. Both episodes are marked in the red boxes below.

Here’s the difference. In 2009, the market crashed. In 2011, the market didn’t. Moreover, many professional investors were positioned for a crash but their performance was hurt by the confusion over the political and economics of the eurozone crisis. As a result, hedge funds and the average long-only manager had a terrible 2011.

The road ahead in 2012
So what happens now?

I would like to discuss the outlook for return and risk for risky assets such as equities. First, because the market didn’t collapse in 2011 as it did in 2008, it would be foolhardy to ascribe near triple digit returns for equities going forward. If there are no accidents, such as a US recession, or a Chinese hard landing, investors should enjoy either high single digit or low double digit returns from a diversified stock portfolio.

The changing risk map
What has changed in 2012 is the map of risk. The actions of the ECB, Federal Reserve and other global central banks have effectively minimized tail risk for investors. Instead of having to worry about a market with a bimodal distribution, which Pimco manager Vineer Bhansali wrote about here, and is shown in the graph on the right below, I believe that stocks and other risky assets have returned to the classic unimodal bell-shaped return distribution shown in the graph on the left.

In other words, instead of worrying about catastrophic events, such as a Creditanstalt-like collapse, we just go back to worrying about earnings, recessions, growth, interest rates, etc. Bimodal distributions are much more difficult for professional managers to deal with because there is a single decision or event that can lead the market in two different directions. Will X default? Will the FDA decision be favorable for the company? How will the court rule in this key case that affects the survival of the company? It was largely these circumstances that led to the poor hedge fund and professional manager performance in 2011.

Unimodal return distributions, on the other hand, are far more manageable and much easier for professional investors to deal with. Modern portfolio theory is based on bell-shaped return distribution functions. Managers are well trained to manage risk in such situations and virtually everyone does it well.

What are the risks?
While I believe that equities are poised for reasonable returns in 2012, there are significant risks to the market. In the short term, I agree with Cullen Roche at Pragmatic Capitalism when he pointed out that investors appear to be overly complacent and due for a corrective pullback, a conclusion also shared by Mark Hulbert.

In the medium term, believe that there are two major macro risks that face the market in 2012. First, there is the risk of a recession in the US, which has loudly trumpeted by ECRI. While the high frequency economic releases have generally been coming in above expectations, which points to a weak but non-recessionary economy, what bothers me is that respected investors who are not permabears, such as Jeremy Grantham and Jeffrey Grundlach, have been cautious.

If the American economy were to move into recession as per ECRI, then we should be seeing its effects now. I would be watching carefully corporate guidance and the body language of management as we go through Earnings Season. Last week, earnings were generally upbeat with the exception of GOOG.

The second major macro risk facing the market is a hard landing in China. While the Chinese economy is showing signs of slowing, the authorities are also taking steps to cushion the slowdown. Most worrying though, is analysis from Patrick Chovanec that indicates that Chinese GDP growth would have been 6.6% had growth from the property sector been flat – which is a brave assumption given the sad state of the property market today. A Chinese GDP growth rate of 6.6% would likely freak out the markets as it is in hard landing territory.

What about Europe?
Conspicuous by absence in my list of macro risks is Europe. I respectfully disagree with John Mauldin when he wrote this week:

As this letter will suggest, I don’t think this is the year you want your portfolio in typical long-only funds. There is a lot of tail risk this year coming from Europe.

In the worse case, consider what might happen if Greece experienced a hard default inside the euro, given that the ECB et al appear to be ready to fight the fire:

Greece defaults.

Banks have to mark to market their Greek paper and Credit Default Swaps get paid out.

Banks become insolvent, but small depositors can get their money because of limited deposit guarantees up to X.

Insolvent banks either get merged with strong banks (not many in Europe), get taken over by their sovereigns and restructured into good bank/bad bank (i.e. taxpayers take the hit), or go bankrupt.

Some investors will get hurt, but there will be no mass panic because of ECB liquidity.

The inter bank market would likely freeze up under such a scenario until there is more clarity about which banks live and which die. In the meantime they live on emergency ECB life support.

Risk premium migrate to the sovereign bond market.

Any crisis will get contained if the ECB prints. The Germans, if they object, will be faced with a choice of a catastrophic failure vs. QE. In the end, I believe that they would choose QE.

This sounds more like a Long Term Capital Management crisis whose effects was contained, rather than a Creditanstalt event that takes down the banking system and set into motion the second leg down in the Great Depression.

We have a situation now where the P/E ratio, based on the trailing 12 months of earnings, is a mere 13. That may not be a classic trough by any means, but only 20 per cent of the time in the past quarter-century has the multiple been this low. That is something for investors to consider.

The multiple based on estimated earnings for the next 12 months – the “forward” P/E – is less trustworthy than the trailing P/E because it depends on analysts’ ability to accurately forecast the coming year. But as it stands, the forward multiple is now just a snick below 12.

In the past quarter-century, we saw only one other time when it was this low on a one-year forward basis, and that was the first quarter of 1988. A year later, the S+P 500 rallied 15 per cent.

That, too, is something to mull over.

For now, my Trend Model is showing a neutral reading and I anticipate some short-term choppiness as the market consolidates and digests the recent gains from the October lows. Beyond the short-term choppiness, equities should show some reasonable returns for the remainder of the year.

Don’t worry, be happy.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest. None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.